NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Flight to Quality and Collective Risk Management

Ricardo J. Caballero, Arvind Krishnamurthy

NBER Working Paper No. 12136
Issued in April 2006
NBER Program(s):   CF   EFG   IFM   ME

We present a model of flight to quality episodes that emphasizes systemic risk and the Knightian uncertainty surrounding these episodes. Agents make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks. Aversion to this uncertainty leads them to question whether their private risk management decisions are robust to aggregate events, generating conservatism and excessive demand for safety. We show that agents’ actions lock-up the capital of the financial system in a manner that is wasteful in the aggregate and can trigger and amplify a financial accelerator. The scenario that the collective of conservative agents are guarding against is impossible, and known to be so even given agents’ incomplete knowledge. A lender of last resort, even if less knowledgeable than private agents about individual shocks, does not suffer from this collective bias and finds that pledging intervention in extreme events is valuable. The benefit of such intervention exceeds its direct value because it unlocks private capital markets.

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Document Object Identifier (DOI): 10.3386/w12136

Published: Ricardo J. Caballero & Arvind Krishnamurthy, 2008. "Collective Risk Management in a Flight to Quality Episode," Journal of Finance, American Finance Association, vol. 63(5), pages 2195-2230, October.

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